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OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006 OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006

Department of the TreasuryOffice of International Affairs

Occasional Paper No. 4August 20061

Overview Of Islamic Finance

DISCLAIMER

Occasional Papers from the Treasury Department’s Office of International Affairs exam-ine international economic issues of current relevance in an effort to identify underlying trends and issues for policymakers. These papers are not statements of U.S. Government, Depart-ment of the Treasury, or Administration policy and reflect solely the views of their authors.

By Mahmoud Amin El-Gamal2

WhAt IS ISLAMIC FInAnCE?

Islamic finance started as a small cottage industry in some Arab countries in the late 1970s. It dis-tinguishes itself from conventional finance in its ostensible compliance with principles of Islamic law, or Shari’a.3 Its growth has been accelerating ever since, in terms of the number of countries in which it operates, as well as the areas of finance in which it has ventured. However, reliable data are not available on Islamic finance at the coun-try, regional or global levels.4 In recent years, the industry has attracted a number of western mul-tinational financial institutions, such as Citigroup and HSBC, which started offering Islamic finan-cial products in some Arab countries (notably Bahrain and the United Arab Emirates), and to a lesser extent in the western world (including the U.S., where HSBC offers various Islamic financial products in New York, including home financing,

checking accounts, etc.). A number of Islamic fi-nancial products also involve the acquisition of assets (e.g., real estate, small corporations, etc.) in the west (including the U.S.) in “Islamically struc-tured” financing deals.

Islamic finance relies crucially on three sets of in-dividuals with complimentary skills: (i) Financial professionals who are familiar with conventional financial products, as well as the demand for “Is-lamic” analogues of those products within vari-ous Muslim communities around the world, (ii) Islamic jurists (fuqha or experts on classical juris-prudence developed mainly between the 8th and 14th Centuries), who help Islamic financial pro-viders to find precedent financial procedures in classical writings, upon which contemporary an-alogues of conventional financial products can be built, and (iii) lawyers who assist both groups in structuring Islamic analogue financial products,

1 This paper was originally written by the author in July 2004. Where necessary, the text has been updated by Treasury International Affairs staff, and the revised paper was reviewed and approved by the author. 2 Mahmoud Amin El-Gamal is Professor of Economics and Statistics at Rice University. He is Chair of Islamic Economics, Finance and Management in the Department of Economics. From May 2004 until December 2004 he was Islamic Finance Scholar-in-Residence at the U.S. Treasury Department. 3 Shari`a literally means “the way” and is the Arabic term for Islamic Law as a way of life, comparable to the Hebrew Hal-achah). Fiqh, commonly translated as jurisprudence, is the interpretation of Shari`a for specific circumstances by specialized fuqha, or jurists. 4 One can find several quoted figures, used primarily for informational purposes. However, there appears to be no reliable statistical basis for those numbers, so we have to settle for qualitative growth description.

OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006

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while ensuring their compliance with all applica-ble and relevant legal and regulatory constraints.5

Due to the industry’s small size, a limited number of key players in each of those three categories have emerged as clear leaders.

hIStoRICAL RootS oF ISLAMIC FInAnCE

In the late 19th Century, the Ottomans intro-duced western-style banking to the Islamic world to finance their expenditures. While some Islamic jurists approved of modern banking practices, the majority found those practices to be violations of Islamic prohibitions against usury (Arabic term: riba, equivalent to the Hebrew ribit, and inter-preted in its classical Biblical sense of any interest charge on loans, as opposed to the modern iden-tification of usury with exorbitant interest). This resentment continued through the European colonial period, which lasted into the mid-20th Century. Islamic revival played a central role in the intellectual and social foundations of inde-pendence movements of the mid-20th Century. To many intellectual founders of the movement, political independence was to be supplemented with economic independence, through the defi-nition of an Islamic economic system.

Early writings on what came to be known as “Is-lamic Economics” focused on macroeconomic developmental issues. By the 1970s, theoretical discussions of Islamic economics had given rise to practical discussions of Islamic finance, which turned juristic in nature: how can Muslims replace (conventional) financial practices (deemed to be usury/riba-based) with Islamic alternatives. Mid-Century literature suggested a profit-and-loss sharing silent partnership alternative to interest-based lending. The Arabic name of this contract is mudaraba, which is akin to the medieval Eu-ropean Commenda contract, and the Jewish Heter

Isqa, designed similarly to avoid usurious lending in Jewish and early Catholic Law.6

This partnership-based focus survives in some Islamic financial practices (e.g., as a substitute for interest-bearing bank deposits). However, with the help of Islamic jurists and lawyers, as discussed in the introduction, Islamic financial practitioners were soon able to provide close an-alogues to almost all financial products, includ-ing various debt-instruments and fixed-income investment vehicles. We shall summarize some of the most widely used Islamic financial modes of operation in the following section.

MoDES oF opERAtIon In ISLAMIC FInAnCE

There are many contract and institutional forms used within the industry collectively known as Is-lamic finance. Specifics vary across countries and sectors. In this overview, we shall concentrate on some of the basic and central modes of financ-ing that are most popular in Islamic finance to-day. When significant differences exist between implementations of a particular Islamic financial transaction in different regions or sectors, we note those differences briefly.

Consumer and Business Loan Alternatives

The juristic-based understanding of forbidden riba/usury suggested that Islamic finance has to be “asset-based”, in the sense that one cannot collect or pay interest on rented money, as one does in conventional banking. Therefore, the eas-iest transactions to Islamize were secured lending operations, e.g., to finance the purchase of real estate, vehicles, business equipment, etc. Three main tools are utilized for this type of retail fi-nancing:

5 In this regard, Islamic finance has to adhere to multiple legal requirements; for clarity, this paper will refer to religious constraints as “juristic”, and reserve the terms “legal” and “regulatory” for sovereign-imposed constraints. 6 On Mudaraba/Commenda, see Udovitch, Abraham L. Partnership and Profit in Medieval Islam. Princeton, N.J: Princeton University Press, 1970. On the Isqa (alternatively spelled Iska) contract, see Stern, J. “Ribit: A Halachic Anthology”, Journal of Halacha and Contemporary Society, 46, 1982. Sample Iska forms are available at: http://www.jlaw.com/Forms/iska_d.html.

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Source: Haver Analytics

a. Buy-sell-back arrangements given the classical Arabic name: murabaha. Under this transaction, the bank obtains a prom-ise that its customer will purchase the prop-erty on credit at an agreed-upon mark-up (interest alternative), then proceeds to buy the property and subsequently sell it to the customer. These are analogous to the Fed-eral Reserve’s use of “matched-sale pur-chases.” Depending on the jurisdiction and the object of financing, this may or may not impose additional sales taxes, license fees, etc. In the U.K., a recent regulatory ruling allowed Islamic financiers (HSBC) to prac-tice double-sale financing without being subject to double-duty taxation. In 1999, at the request of United Bank of Kuwait (UBK), which at the time offered an Islamic home financing program in the U.S. (called Manzil USA, the program was terminated shortly thereafter), the Office of the Comptroller of the Currency issued an interpretive letter declaring Murabaha financing to be “func-tionally equivalent to or a natural outgrowth of secured real estate lending and inventory and equipment financing, activities that are part of the business of banking”. 7 The mark-up in Murabaha financing is benchmarked (i.e., made to track) conventional interest rates.

b. Lease-to-purchase or diminishing part-nership arrangements under the Arabic names Ijara or Musharaka Mutanaqisa. A typical structure requires the bank to create a special purpose vehicle (SPV) to purchase and hold title to the financed property. The SPV then leases the property to the cus-tomer, who makes monthly payments that are part-rent and part-principal. Rents are calculated based on market interest rates, allowing monthly payments to follow a con-ventional amortization table. The juristic justification of this practice is that principal

parts of monthly payments increase the cus-tomer’s ownership in the property, and allow him to pay less rent (on the part ostensibly owned by the bank through the SPV) over time, thus replicating a conventional amor-tization table. Again, at the request of UBK, the Office of the Comptroller of the Cur-rency examined the typical structure of Is-lamic lease-to-own (Ijara) transactions, and reasoned as follows:8 “Today, banks structure leases so that they are equivalent to lending secured by private property ... a lease that has the economic attributes of a loan is within the business of banking... Here it is clear that UBK’s net lease is functionally equivalent to a financing transaction in which the Branch occupies the position of a secured lender...”.

An added advantage to lease financing is that Islamic jurists allow the SPV to issue certificates securitizing the lease (ostensi-bly, the certificates represent ownership of the underlying asset, and thus allow their holders to collect rent). In recent years, this has given rise to a booming securitization industry in Islamic Finance, as we shall dis-cuss within the context of bond-alternatives. Here in the U.S., both Fannie Mae and Fred-die Mac have purchased and guaranteed Ijara-based mortgages, subject to their note requirements (which required overcoming some legal and juristic hurdles). Those Is-lamic mortgage-backed securities are cur-rently being marketed as fixed-income in-vestment alternatives for Muslims.

c. Recently, banks in Gulf Cooperation Council (GCC) countries have been of-fering consumer finance through a three-party contract known by the Arabic name Tawarruq (literally: monetization of some commodity). This is a practice that Islamic banks have used with more sophisticated business clients for a number of years, but only recently introduced for consumer fi-

7 Available on the OCC website at: http://www.occ.treas.gov/interp/nov99/int867.pdf. 8 See http://www.occ.treas.gov/interp/dec97/int806.pdf.


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nancing. For example, a customer wants to borrow $1000 using an Islamic Juristic-compliant mechanism. GCC Islamic jurists, relying on an opinion within the Hanbali school of jurisprudence, which is dominant in that region, allow the bank to buy $1,000-worth of commodities (e.g., wheat), and sell them to the customer on credit at a mark-up (equal to the interest rate they would have charged on a loan, perhaps plus compensa-tion for the transaction costs associated with multiple sales). The customer may then turn around and sell the commodity to a third party (oftentimes the same party that sold it to the bank), collecting the desired cash immediately, with a deferred debt equal to principal plus interest. In 2004, at least one other bank in a GCC country announced a new Tawarruq facility. Since this type of fi-nancing can easily replace lending for any purpose (consumer loans, unsecured loans, etc.), it has allowed a number of conven-tional banks to announce that they will “Islamize” all of their operations. The most significant such announcement was that made by Saudi Arabia’s National Commer-cial Bank, stating that it planned to Islamize all of its lending practices by 2005.

Corporate and Government Bond Alternatives

In its early stages of development in the 1980s and 90s, a number of bond alternatives were tried with very limited success. Some were based on profit and loss sharing (e.g., in Sudan and Pakistan), while others guaranteed the principal but did not guarantee a fixed rate of return (e.g., in Malaysia). Once the securitization of leases (discussed in the previous section) became fully understood, a significant number of corporate and government bonds were structured as lease-backed securi-ties (under the Arabic name Sukuk al-Ijara).9 In

2004, the largest issuance was by the Department of Civil Aviation of the United Arab Emirates for $750 million. The second largest was by the Bah-rain Monetary Agency for $250 million. The latter was led by Citigroup, with heavy involvement of the Norton Rose law firm to structure the deal. A third interesting government issuance was by the German Federal State of Saxony-Anhalt for €100 million, which is heavily marketed in the Arab countries of the GCC as the first western-govern-ment issued Islamic bond. The two largest cor-porate Islamic bond issuances in the first half of 2004 were those of the National Central Cooling Company (of U.A.E.) for $100 million and Hanco Rent a Car in Saudi Arabia for $26.13 million.

Corporate bond issuances in the early part of 2006 totaled $10.2 billion, the most notable being the Dubai Ports issuance of the largest sukuk to date, a 2 year convertible $3.5 billion bond (profit and loss sharing).10 In 2005, an estimated $11.4 billion in corporate sukuks were issued, up from $5.5 billion and $4.6 billion in 2004 and 2003 re-spectively. Sovereign issuances in 2006 total $2.7 billion thus far, up from $706 million in 2005, $1.5 million in 2004 and $1.2 million in 2003.11 An ad-ditional $6.7 billion in sovereigns is slated to be issued for the remainder of 2006.12

A number of those issuances were made by SPVs, which buy some properties from the respective governments or corporations using bond-sale proceeds, and then lease the properties back, passing principal and interest back to bond-hold-ers in the form of rent. A number of different U.S. and European investment banks are involved in the securitization process (e.g., Citigroup for the Bahraini and German state bonds, Credit Suisse First Boston for the UAE cooling company, and Barclays Bank with the Dubai Islamic Bank for the Dubai Ports Co.).

9 Sukuk is the plural of sakk, an Arabic precursor of cheque, meaning certificate of debt or bond. 10 Managed by Dubai Islamic Bank and Barclays Bank. Details about the sukuk structure, and thus about potential risk-structure differences from conventional bonds, are not available. 11 Sovereigns include government-owned institutions, utilities,etc. 12 Source: ISI Emerging Markets’ Islamic Finance Information Service (IFIS). Data as of May 2006.

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Lease-backed bonds are long-term securities, for which underlying physical assets allow secondary markets to exist. Shorter-term (Treasury bill-like) bonds are also issued on occasion by govern-ments of countries with significant Islamic bank-ing operations (e.g., Bahrain). Those are typically based on forward sales of some commodities, us-ing the Arabic name salam, and adhering to the classical juristic ruling that price must be paid in-full at the incep-tion of a salam-sale. By utilizing what is called a “parallel salam”, the bond-issuer can match a for-ward-purchase with a purchase-sale for the same commodities and the same delivery date, but ini-tiated at different times. Thus, corn deliverable in six months can be sold forward today for $1 mil-lion, and then bought forward in three months (using a separate contract with a different coun-terparty) for $1.01 million. While residual credit, commodity and delivery risks may exist in this structure, issuers typically guarantee the contract so that the bond buyers would – in our example – be guaranteed 1% in 3 months. Since the un-derlying assets for this type of bond are debts, Is-lamic jurists ruled that they cannot be traded on secondary markets (except at face value, which defeats the purpose). Thus, they were originally envisioned as vehicles primarily for Islamic banks to hold to maturity. Recently, however, Bahrain has introduced some innovative repo (repurchase) facilities, to allow Islamic banks to use those bills more effectively for liquidity management.

Investment Vehicle Alternatives (e.g., Mu-tual Fund, private Equity)

For investment in corporate equity, it was easy to see why Islamic investors should shy away from companies that produced products that are forbidden to Muslims (e.g., beer, pork products, etc.), as well as some others that Islamic jurists decided to forbid (e.g., weapons producers, cut-ting-edge genetic research, etc.). The issue of in-terest was much more difficult: Most companies either have excess liquidity – in which case they earn interest, or use leverage – in which case they pay interest. Islamic jurists decided to invoke the rule of necessity (the universe of equity securities to choose from would be too small if they exclude

all companies that either pay or receive interest). They decided to impose three financial screens: (i) exclude companies for which accounts receiv-ables constituted a major share of their assets; (ii) exclude companies that had too much debt; and (iii) exclude companies that received too much interest. After experimentation with different cut-off marks for financial ratios, the set of rules se-lected by the Dow Jones Islamic indices became globally accepted: (i) exclude companies whose receivables accounted for more than 45% of as-sets; and (ii) exclude companies whose debt to moving average of market capitalization exceed 33%. Many add a third rule related to the first: (iii) exclude companies whose interest income exceeds 5% (or, for some, 10%) of total income.

Dow Jones, and later Financial Times, launched their Islamic indices in the late 1990s, and contin-ue to add various other Islamic indices paralleling their other conventional indices, with the smaller universe of equity securities. Mutual fund com-panies either mimic their screening rules, or ob-tain licenses from one of the indices, which they use as a benchmark. These types of mutual funds are usually dubbed “Islamic” or “Shari`a-compli-ant.” While sales of mutual funds in general have done well in Saudi Arabia and GCC markets, Is-lamic mutual funds seem to have only a limited marketing advantage over conventional ones. In one study done by National Commercial Bank in Saudi Arabia, investors indicated that all other things equal, they would prefer an “Islamic” fund to a conventional one. However, if other things are not equal, they would prefer a conventional fund with better returns, or offered by a more reputable provider, to ones that are “Islamic” but inferior along those dimensions. Consequently, the total funds under management by Islamic mutual funds have – to date – fallen substantially short of initial expectations.

On the other hand, growing unanimity over the general screens used by Islamic mutual funds has enabled Islamic private equity and investment banking boutiques to thrive. Those institutions typically collect investor funds in GCC countries (investors from Saudi Arabia, Kuwait, and U.A.E.


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being primary sources of funds). Through local subsidiaries or partners in the west (U.S.A. and U.K. being primary destinations for investment funds), collected funds are used to acquire real estate and small companies that pass the above mentioned screens, or whose debt can be restruc-tured to pass them (oftentimes through lease-based leveraged buy-outs, a popular western mergers and acquisitions tool of the 1980s and 1990s). There are 134 registered equity funds, six hybrid funds, six sukuk funds, two Takaful funds (insurance), five leasing funds and eight real es-tate funds.13

Insurance Alternatives

The vast majority of Islamic jurists declared the use of, and investment in, insurance companies to be impermissible under Islamic jurisprudence. This prohibition is based on two considerations: the first consideration is that “safety” or “insur-ance” is not itself viewed as an object of sale in classical Islamic jurisprudence. Thus, Islamic ju-rists argued, the insured-insurer relationship is viewed to be one akin to gambling, wherein the insured as buyer pays periodic premia as price, but may or may not receive the object of sale (com-pensation in case of loss), depending on chance. The second consideration that prompted Islamic jurists to forbid insurance is the fact that insur-ance companies tend to concentrate their assets in interest-based instruments such as govern-ment bonds and mortgage-backed securities.

The alternative they proposed is marketed un-der the Arabic name Takaful, which has recently begun making inroads in Islamic countries, after years of slow growth. The main idea behind Taka-ful is similar to mutual insurance, wherein there is no commutative financial contract that allows one to interpret premium payments as prices and insurance claim fulfillment as an object of sale. Rather, policy holders are viewed as contributors to a pool of money, which they agree voluntarily

to share in cases of loss to any of them. Early Takaful companies were in fact structured as stock insurance companies, but the language of “vol-untary contribution” to insurance claimants was used to argue that the contract was not a com-mutative one. Inroads have recently been made by Bank Al-Jazira of Saudi Arabia by modifying its insurance to better approximate western-style mutual insurance, and the model appears to be boosting its underwriting success. Regardless of structure, both types of Takaful companies do not invest in conventional government bonds and fixed income securities. However, as seen elsewhere in this section, Islamized analogues of those securities have become increasingly avail-able in recent years, further contributing to the industry’s growth. Despite the industry’s growth, it has not yet reached a critical size that would support the equivalent of re-insurance, or “re-Takaful”, companies to emerge. Consequently, Islamic jurists have invoked the rule of necessity to allow Takaful companies to sell their risks to conventional re-insurance companies, with the provision that they should work to develop a re-Takaful company as soon as possible.

Bank Deposit and Fixed Income Security Alternatives

In the Islamic world, Islamic banks can only ac-cept fiduciary deposits, for which they cannot pay interest, since interest would be considered usury/riba once the principal is guaranteed. On the other hand, they are allowed to accept “in-vestment account” funds, which they may in-vest on behalf of the account holders, and share profits and losses thereof. This clearly gives rise to a moral hazard problem, and a regulatory is-sue regarding protection of investment account holders who are neither protected as creditors (first claimants), nor as stock-holders with rep-resentation on boards of directors. Attempts by significant juristic bodies to justify interest-bear-ing bank deposits have been strongly rejected by most Islamic jurists, especially the ones to whom

13 As of February 2006. www.failaka.com. 14 For a summary of this debate and its juristic grounds, see El-Gamal, Mahmoud “Interest and the Paradox of Contempo-rary Islamic Law and Finance”, Fordham International Law Review, December 2003.

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Islamic bank customers look for guidance.14

In the U.S., a number of attempts took place in the U.S. to license an Islamic bank, a number of conventional banks are offering Islamic financing products, and working towards offering FDIC-insured variable-interest (tied to rate of return on portfolio of Islamic mortgage, auto-financ-ing, etc.) NOW, money market, and other types of bank accounts. Interpretation of such services as “deposits” is controversial, and their appeal to target clientele is uncertain. In particular, and in analogy to the limited appeal of Islamic mutual funds, it may be the case that potential Islamic bank customers who are sufficiently sophisticat-ed to accept deposit insurance will also be suf-ficiently sophisticated to seek the best combina-tions of returns and offering institution-size. On the other hand, the novelty of “Islamic banking” availability, coupled with the possibility of obtain-ing FDIC insurance of the principal, may prove to be sufficiently attractive for a group of Muslims who have so-far shied away from depositing their funds in savings or money market accounts, as well as others who have such accounts but prefer to buy the “Islamic” brand-name.15

In the meantime, as we have shown, market-based fixed-income alternatives have been available for quite some time based on securitization. Thus, Islamic finance clients can buy Islamic mortgage-based securities, or invest directly in pools of se-curitized fixed-return Islamic financial products. In this regard, while securitized Murabaha (cost-plus credit sale receivable) portfolios are deemed non-tradable except on face value, Islamic jurists have allowed trading mixed portfolios of sale-based and lease-based receivables, provided that the latter constitute at least 51%. If the market for Islamic-finance assets continues to grow, the ability to offer all types of fixed-income instru-ments, including bank savings accounts, should become more common in the West. It may take time for Middle-Eastern and Asian clients to ac-

cept this notion, given the vigor with which they have constantly argued against interest-based transactions as the forbidden Riba.

GEoGRAphIC DIStRIButIon oF ISLAMIC FInAnCE

Intensive efforts have been spent in recent years to harmonize Islamic financial practices, from cre-ating accounting standards for Islamic financial products (through the Accounting and Auditing Organization for Islamic Financial Institutions, AAOIFI), to integration of those standards with global corporate and risk management standards (i.e., Basel Accords I and II) through the recently created Islamic Financial Services Board (IFSB). Those efforts are motivated by two objectives: (1) to create a worldwide network of financial mar-kets, including the offshore markets in Labuan (off the Malaysian coast), Bahrain, and Dubai, thus enhancing depth and liquidity of markets for industry securities; and (2) to integrate the indus-try more effectively with the international finan-cial system. However, country and region-specific features have not faded away. We list some of the defining features of Islamic finance in the various relevant sub-regions in this section.

Gulf Cooperation Council (GCC) Countries

Not surprisingly, the rise of Islamic finance in the late 1970s coincided with the two oil shocks of that decade, which created an immense amount of wealth. The earliest private Islamic banks of the modern era were Dubai Islamic Bank, Faisal Islamic Bank Egypt, and Faisal Islamic Bank Su-dan, the latter two being sponsored by Prince Muhammad Al-Faisal, son of the late King Faisal of Saudi Arabia. Other early entrants in the in-dustry were the various financial arms of Saudi Sheikh Saleh Kamel’s Dallah Al-Baraka groups, and Kuwait Finance House, among others.

In its early stages, most governments in the GCC

15 For instance, a small market exists for “Halal (permissible) meat”, analogous to Kosher products, based on specific slaughter and processing procedures. Those products appeal to customers who otherwise would only consume vegetarian products, as well as others who would buy regular meat products but prefer to buy “Halal” meat.


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region, and the Arab world more generally, were either hostile to, or at best ambivalent about, Is-lamic finance. Indeed, to most people’s surprise, the latest country to allow Islamic banking in the region is Saudi Arabia, where the Saudi Arabian Monetary Authority has always been concerned about and averse to introducing non-standard banking practices.

However, demand for financial products allowed a number of local and western financial practitio-ners to create a small industry, using investment funds from the Gulf region, especially Saudi Ara-bia. Over the past decade, Bahrain has pursued Islamic finance as a significant niche that could allow it to build on its strong banking sector, per-haps to become a regional financial center. Lo-cal investment banking talent also emerged in Bahrain (e.g., First Islamic Investment Bank) and Kuwait (e.g., The International Investor) to capi-talize on the growing industry, which had earlier centered in London and Geneva. Not to be out-maneuvered, a number of multinational financial institutions (e.g., Citigroup, HSBC, and UBS) set-up Islamic financial arms in the region (mainly in Bahrain and U.A.E.) to cater to commercial as well as investment banking needs within the Is-lamic finance niche.

Islamic finance arms of multinational banks, with their superior resources, later helped indigenous Islamic finance companies to establish the Ac-counting and Auditing Organization for Islamic Financial Institutions (AAOIFI), and most re-cently initiate the drive to get Central Banks, as well as the IMF and World Bank, to establish the Islamic Financial Services Board in Kuala Lum-pur, Malaysia. We have already seen the primary role played by multinational investment banks in the most recent wave of Islamic bond issuances, both by sovereign states in the region (Bahrain and Qatar), as well as corporations.

Southeast, South and Central Asia

Malaysia developed one of the earliest mature Islamic finance markets in the mid-1980s. Initia-tives to integrate ethnic Malays in the country’s

formal financial sector culminated in converting a pilgrimage savings plan into a full-fledged Islam-ic bank: Bank Islam Malaysia Berhad. Over the next two decades, conventional Malaysian banks were allowed to offer Islamic financial products through “Islamic windows”. Malaysia’s central bank, Bank Negara, began supervision of Islamic banking practices at its inception. Special bonds called Government Investment Certificates were issued to facilitate open market and inter-bank operations. Those bonds guaranteed the princi-pal, but gave interest only as an unanticipated gift based on profitability of government investments. Malaysian Islamic money markets were success-ful early on, and attracted some investment capi-tal from GCC investors eager to invest some of their capital in Islamic countries.

However, as advanced as the Malaysian Islamic financial sector was relative to its Arab counter-parts, it suffered a fundamental drawback. Much of the development of that sector relied on a ju-ristic opinion held by Malaysian Islamic jurists, who allowed trading debts and pure-debt instru-ments. That allowed Malaysia to evolve a highly efficient parallel Islamic financial system. How-ever, Islamic jurists of other regions did not ap-prove of this debt-trading practice. As the Arab market grew, and Malaysia feared that Bahrain would replace London as the sole center of global Islamic finance, Malaysians strove to harmonize their Islamic financial markets with Islamic finan-cial practices elsewhere in the world. To empha-size its leading role in this industry, the Malay-sian central bank led the creation of the Islamic Financial Services Board, which is now housed in Kuala Lumpur and relies on Malaysian contri-butions for running expenses. In the meantime, Malaysians continue to allow more innovation for their own domestic Islamic financial market, allowing conventional futures trading, debt trad-ing, etc., and recently creating a deposit insurance mechanism for Islamic banking. Other countries in Southeast Asia, e.g., Indonesia, Singapore, etc. have relatively small Islamic financial sectors, which are likely to evolve as a hybrid between the Malaysian and the more conservative Arab and Pakistani models.

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Pakistan is another interesting case to consider. General Zia-ul-Haqq, in his many efforts to use Islamic fervor for his regime’s legitimacy, de-clared full-fledged Islamization of the financial sector in the 1980s. However, bankers merely continued their conventional banking practices, replacing the term “profit” with “interest”. The Pakistani Shari`a Appellate Court repeatedly is-sued ultimatum orders to Islamize the system for real at various dates, but that proved impossible. A new Islamic banking initiative was started in 2004: there are four Islamic banks, two are in the pipeline and 15 conventional banks have Islamic branches. The State Bank of Pakistan (the Cen-tral Bank) appointed its own 5-member Shari’a board (Islamic juristic authority) composed of an Islamic jurist, accountant, lawyer, banker, and central bank representative and has posted a list of permissible Islamic banking contract forms on its website. This may be a prelude to more gen-eral imposition of Islamic banking practices in Pakistan.

Iran also declared the Islamization of its banking sector shortly after the Islamic revolution. How-ever, since most banks were either national or nationalized, interest payments between those banks were seen to cancel out in the consolidat-ed balance sheet, and were therefore permitted. For dealings with the public, some banks did not guarantee interest rates, but in practice paid rates equal to the interest rates determined elsewhere in the system. Hence, Iranian banking has not changed significantly before and after the revolu-tion. Finally, a small number of boutique Islamic financial shops started in the various “stans” (es-pecially Kazakhstan) in recent years, but there are no signs of an Islamic financial industry evolving in central Asia at this time.

Arab World excluding GCC

As previously noted, Faisal Islamic Banks in Egypt and Sudan were among the very first Islamic banks. Faisal Islamic Bank Egypt was established by special decree, and Islamic banking in Egypt remains extremely limited, although some state banks are allowed to offer Islamic transactions to fulfill the market demand. Official and public per-

ceptions of Islamic banking in Egypt were severe-ly damaged in the aftermath of massive failures of Islamist “fund mobilization companies” that ap-parently attracted remittances of many Egyptians working in GCC countries, ostensibly to invest in trading real assets, but in fact constituted pyramid schemes.

In contrast, Sudan Islamized its entire banking sector. A very conservative (and hence relatively inefficient) version of Islamic finance is followed in Sudan, for instance with government bonds based on profit-and-loss sharing partnerships. There are indications currently that banks in the Southern part of Sudan will be allowed to operate conventionally or Islamically as they please, while banks in the north will remain purely Islamic.

Elsewhere in the Arab and Islamic world, a num-ber of GCC-based banks have had Islamic opera-tions for a number of years. The general rise in Islamic sentiments in the region is accompanied with high levels of adherence to classical law in all matters ranging from dress-codes to finance. Consequently, countries that originally resisted Islamic banking are currently inviting it to sat-isfy their nascent demand. Recently, for instance, Lebanon increased substantially its Islamic bank-ing profile with Saudi-based Al-Baraka, and Syr-ia licensed its first Islamic bank, which is jointly Qatar-Syrian owned. One can expect private Is-lamic finance to continue to grow substantially all around the Arab and Islamic world. Depending on political environment, some governments may even opt for Islamization of some state-owned banks as a measure to limit capital flight and ap-pease Islamist elements within their borders.

north America and Western Europe

Islamic finance has arisen in the West primarily as a result of the popularity of U.S., and to a lesser extent U.K. and German, financial assets among GCC investors, who are the primary financiers of Islamic finance. Whether we consider Islamic mutual funds that select among stocks on the NYSE and NASDAQ, commercial real estate in-vestment, or acquisition target corporations, those


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investors favor the legal transparency and lower risk associated with mature western markets. These investment preferences did not change af-ter September 11, 2001. However, a combination of fear of asset-freezing dragnets and public im-age consciousness about being heavily invested in the West prompted indigenous and multinational Islamic finance providers to restructure transac-tions in a manner that gives those investors indi-rect investment access to those markets.

For the past three decades, Islamic finance prac-titioners have also attempted to tap the relatively educated and professional Muslim populations in the west (again, primarily the U.S. and U.K.). Arab banks have tried repeatedly, with mixed success, to engage in home and auto financing in the U.S. and U.K. (Al-Baraka was one of the earliest, United Bank of Kuwait coming later and utilizing some of its models). Most recently, Is-lamic Bank of Britain, Plc. (in part pioneered by Abu Dhabi Islamic Bank) was licensed in the U.K. in August, 2004. Western home-grown bou-tique financial institutions, structured as co-ops, savings and loans, and investment companies, also started in the late 1970s and 1980s, but re-mained very small in size. Recently, the securiti-zation successes through participation of Fannie Mae and Freddie Mac have allowed the market for Islamic home financing to grow significantly in the U.S., with some providers seeking to sell hundreds of millions worth of GSE-guaranteed mortgage backed securities in GCC countries, as cheaper alternatives to investment banking and boutique private equity financial instruments. Participants in this industry, home-grown and foreign, have recently had a number of regulatory successes, including the above cited OCC letters, and potential FDIC approval of various deposi-tary products in the U.S., as well as licensing of the first full-fledged Islamic bank and elimination of double-duty taxation for HSBC Islamic home financing in U.K. Islamic finance is likely to con-tinue to grow in the U.S. and western Europe, but not to the extent expected by market participants who hope that a significant proportion of Mus-lims in those countries will participate in this in-dustry. For instance, while Islamic mutual funds are widely accessible, they have only attracted a

very small percentage of savings of Muslims in those countries. The market-size for Islamic mu-tual funds was over-estimated, and market-sizes for other Islamic financial products – estimates of which prompted many recent developments in legal and regulatory infrastructures – may very well be likewise over-estimated.

pRoS, ConS, AnD pRELIMInARy poLICy ConCLuSIonS

Islamic finance is an industry which in many ways tries to “reinvent the wheel,” producing suc-cessive approximations of western financial prac-tices. However, it is an industry that is likely to survive in the medium term, due to continued existence of customers who value Islamic jurist approval of its modes of operation. To the extent that Islamism in all its forms is on the rise, the industry is likely to continue to grow, but I be-lieve its growth prospects are limited. However, its absolute size (though not known accurately) has already reached levels that require monitor-ing the sector, and ensuring the development of appropriate prudential regulations therein as well as harmonious development within the interna-tional financial system. We close with a list of the most important pros and cons of Islamic finance in the short to medium-term.

Islamic finance may have already succeeded in integrating some part of the global Muslim pop-ulation (those who had decided not to deal with conventional finance) in the formal international financial system. In the process, Islamic jurists were forced to analyze classical Islamic jurispru-dence in light of contemporary legal, regulatory, economic and financial systems. This gave rise to a continuing process of growth in Islamic ju-risprudence, which ultimately may further pro-duce an efficient integration of Muslims who had previously shunned the conventional financial sector. Moreover, recall that the primary mar-ket for Islamic finance is in developing countries – which may have formally borrowed modern legal, regulatory, and financial standards from advanced countries, but fall significantly short of

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those standards in practice. In this regard, one may recall that provisions in laws of contracts under classical Islamic jurisprudence were, in es-sence, prudential regulations of that time. To the extent that those provisions are respected in Is-lamic financial practice (which is not necessarily the case), Islamic finance may in fact be a catalyst for improving financial practices in those coun-tries. For instance, the focus on secured rather than unsecured lending (albeit being abandoned with the growth of Tawarruq financing), coupled with proper marking-to-market of asset val-ues, can improve collateralization practices that have been non-existent or poorly implemented in some majority-Muslim countries, leading to catastrophic bad loan volumes that threaten their banking systems.

On the other hand, one cannot but conclude that the modus operandi of Islamic finance, including the evolving opinions of its professional Islamic jurists, is a prolonged reinvention of the financial wheel. One needs only to observe the evolution of standards from original practices of Murabaha, to more advanced Murabaha with agency provi-sions, and finally Tawarruq practices, to notice how competition and better understanding of banking practices brings Islamic financial practice closer to its conventional counterpart. However, the industry’s survival to-date has relied on its cap-tive market of pious Muslims, who may abandon it if full convergence is obtained. Moreover, just as some manufacturers may delay the introduc-tion of their latest products to smooth demand over time, Islamic financial providers prefer to introduce “innovations” (better approximations of conventional financial practice) gradually, to ex-tract the most rents, and gently prepare their cli-

entele. This implies that some level of inefficiency is intrinsic to this industry, taking the forms of transactions costs, additional legal costs, and fees for Islamic jurists. Moreover, the industry by its very nature has a longer lag in “chasing past re-turns.”16 However, due to catering to a captive clientele, the industry has been able to survive and continue its growth despite this continued inefficiency.

With time, competition is likely to reduce ineffi-ciency in the industry (though it cannot be elimi-nated if the industry were to maintain its Islamic character). To attain higher levels of efficiency, Is-lamic jurists will have to continue their process of understanding modern financial practices, and developing an Islamic jurisprudence that is appro-priate for today’s legal, regulatory, and financial realities. In this regard, while some developments facilitate Islamic finance (e.g., the English elimi-nation of double duty taxation on HSBC Islamic financial structures involving double-sale for fi-nancing purposes), one should not encourage regulatory adjustments to accommodate Islamic financial practices. Islamic finance has shown its ability to adapt to existing regulatory frameworks (e.g., recent attempts to develop FDIC-insured Islamic money market accounts, CDs, and NOWs in the U.S.).17 I have also argued that this adapta-tion eventually changes the very Islamic jurispru-dence upon which the industry is built. Toward that end, regulators’ primary concern should con-tinue to be protection of consumers of financial services, as well as safety, stability, and fairness of the overall financial system. To the extent that current Islamic jurisprudence has not yet reached a level of maturity that allows it to coexist harmo-niously within the best legal and regulatory stan-

16 For instance, Islamic REITs are currently very popular (June 2004), when REITs were in fact a very good investment in 2001-2. Similarly, a number of new “Islamic Hedge Funds” are beginning to reach the market now, again years after the optimal performance of conventional hedge funds. This chasing of past returns has proved taxing in the past. For instance, the Dow Jones Islamic Index (DJII) debt ratio screen was originally set for debt to assets. In the middle of the tech bubble in the late 1990s, jurists changed the 33% cutoff for debts to assets into one for debts to market capitalization (just as market capitalization was soaring). That allowed DJII-licensed mutual funds to make spectacular returns for a very short period of time, by being NASDAQ heavy. Once technology sector stocks crashed, many of the stocks had to be excluded from the DJII universe because their market capitalizations had fallen too low (i.e., they bought high and sold low), disal-lowing investors to benefit from the partial recovery that ensued. 17 NOWs are negotiable order of withdrawal accounts


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dards, it would be unwise to push market par-ticipants toward standardizing their financial and religious-legal standards at this time. Premature standardization of the current inefficient practices may become tantamount to irreversible codifica-tion of what can be considered an anachronistic financial model.

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